Enhancement of a capital asset for sale does not point to a trading intention, the court held in the Sheng Kung Hui case

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1 News Flash Hong Kong Tax Enhancement of a capital asset for sale does not point to a trading intention, the court held in the Sheng Kung Hui case September 2014 Issue 11 In brief The Court of Appeal (COA) handed down its judgment in Church Body of the Hong Kong Sheng Kung Hui & Hong Kong Sheng Kung Hui Foundation v CIR on 11 September This case concerns whether the profits derived by the taxpayers (which are charitable bodies) from the sale of certain properties located on the redeveloped land are trading profits and subject to Hong Kong profits tax. The case involves two key issues, namely (1) whether there was a change of intention, in relation to the land owned by the taxpayers, from capital holding to trading and (2) if there was a change of intention, whether the profits derived from the redevelopment of the land should be exempted from taxation pursuant to a special exemption for charitable bodies provided for in the tax law. The COA overturned the decisions of the Board of Review (the Board) and the Court of First Instance (CFI) and held that there was no change of intention from capital holding to trading up to the period of time within which the taxpayers had engaged in various activities to enhance the value of the land for realisation. However, the COA did not rule on whether a change of intention occurred at a later point of time and remitted the case back to the Board for it to consider that issue. Given the conclusion on the first issue, it is not necessary for the COA to decide on the second issue of whether the taxpayers qualified for the tax exemption for charitable bodies but the COA did make a few comments on that issue. One key message for taxpayers from the COA s judgment in this case is that activities within certain scope performed by a taxpayer to enhance the value of its capital asset before disposal would not necessarily render the transaction an adventure in the nature of trade. However, taxpayers need to be cautious about what are being regarded as going beyond that safe zone. Another key message is great care needs to be exercised by a taxpayer in the various stages of the tax appeal process (e.g. in drafting the questions of law in the stated case and in considering whether to challenge the Board s decision not to include certain questions in the stated case by means of judicial review) as that may eventually affect the taxpayer s ability to make certain submissions or put forward certain arguments when the case is heard in the court. In detail Background of the case In this case, two charitable bodies of Hong Kong Sheng Kung Hui (i.e. the taxpayers) owned land in Tai Po together since the 1930s with part of the land occupied by an orphanage. In September 1989, the taxpayers were seriously considering relocating the orphanage and redeveloping the land. Thereafter, a series of actions were taken by the taxpayers between 1990 and 1998 which eventually led to the sales of certain residential units and car parking spaces on the redeveloped land with substantial profits. The table in the Appendix summarises the various actions taken by the taxpayers in redeveloping the land and disposing the redeveloped properties together with the timeline of those actions. Profits tax assessments were issued to the taxpayers in respect of the profits made from sales of the redeveloped properties. The taxpayers appealed against the assessments to the Board based on the following grounds: There was no change of intention in respect of the purpose of holding the land. The land had always been held for investment purpose and not for trade.

2 As an alternative, any change of intention only occurred (1) in August 1993 when the taxpayers accepted the tender from a property developer for forming a joint venture for redeveloping the land into a private residential area or (2) in December 1993 when the taxpayers entered into a joint venture agreement with that property developer for the redevelopment. Section 88 of the Inland Revenue Ordinance (IRO), which exempts approved charitable institutions from tax, should be applicable as the conditions specified in that section were satisfied. Decisions of the Board and the CFI The Board affirmed the assessments and held that although the taxpayers initially acquired the land as a capital asset, there was a change of intention from capital holding to trading by September 1989 (when the reprovisioning of the orphanage had been treated as a separate project and the taxpayers applied for planning permission for the residential development) or December 1990 (when the taxpayers applied for a land exchange to permit the building of the residential development as approved) at the latest. Matters that the Board had taken into account in its conclusion include: (1) change in the nature of the use of the land; (2) the taxpayers approached the redevelopment on commercial principles; (3) appointment of professional advisers including architects and lawyers to work on the redevelopment; (4) applying for planning permissions to redevelop the land; (5) applying for land exchange and the granting of the exchange; and (6) active marketing of the disposal of the land by the taxpayers by approaching developers in Hong Kong for offers and tenders. carrying out of the expressed objects of such institution. On appeal by the taxpayers, the CFI upheld the Board s decision as it found that the Board's conclusion was not perverse or unreasonable based on the evidence adduced. The taxpayers then further appealed to the COA. The judgment of the COA The two issues put forward for the COA to consider in the appeal are: Whether there was any change of intention from capital holding to trading/business, whether by September 1989 or December 1990 or at all. Whether section 88 of the IRO should apply if there was a change of intention. Change of intention The COA overturned the CFI s judgment and held that there was no change of intention from capital holding to trading by September 1989 or December 1990 on the following grounds: The purpose of acquiring the land was not for trading purpose. Realisation of the land would not turn it into trading even with the work done on the land for the purpose of maximising the profit in the disposal. Land owners can, to a certain extent, enhance the value of their land for realisation purposes. In this case, the various enhancement activities (e.g. engaging professionals to work on the development, seeking planning permissions and applying for land exchange) taken by the taxpayers in the period up to December 1990 were merely part of the process of realising the land to achieve the best return. These enhancement activities would not cause the realisation of asset to become a business and do not mean the taxpayers were then engaged in trading. This argument is referred to as the Enhancement for realisation principle 1 in the case. date of change of intention as found by the Board. As for the issue of whether the change of intention occurred on some other subsequent dates, the COA held that due to the lack of analysis by the Board on this issue, the issue could only be decided by the Board when the matter is remitted to it for consideration. The COA therefore remitted the case to the Board for it to consider whether the change of intention occurred in August 1993 or December 1993 or alternatively some other date or dates (other than September 1989 or December 1990). Application of section 88 of the IRO Given the COA found that there was no change of intention in September 1989 or December 1990, it is not necessary for it to rule on whether section 88 of the IRO applied to the taxpayers. However, in its obiter dictum, the COA made some important observations regarding the application of section 88 as well as the general rules of the tax appeal procedures as follows: The Board also held that section 88 of the IRO was not applicable since the taxpayers failed to discharge their burden of proof in providing sufficient evidence to demonstrate that the three conditions specified in the section were satisfied, namely (1) the profits The taxpayers only accepted the As a matter of proper construction are applied solely for charitable HKSAR Government s terms of of the IRO, the words expressed purposes; (2) the profits are not the land exchange, invited objects in section 88(a) of the expended substantially outside Hong submission of tender offers and IRO must refer to the written Kong; and (3) the trade or business entered into a joint venture object. Accordingly, the expressed carried on by the charitable institution agreement with the selected objects of the taxpayers must be from which the profits are derived is property developer in 1993, which something already in writing and exercised in the course of the actual was nearly three years after the cannot be put together through a 2 PwC In this case, the taxpayers contended that the Board should not disregard the witness statement and oral testimony of a witness called upon by the taxpayers. However, the COA held that as a tribunal of fact, the Board is fully entitled to decide the extent to which a piece of evidence should be accepted and how a piece of accepted evidence should be put to use. The taxpayer previously sought to pose a question of law in the stated cases to challenge the Board s findings about absence of evidence in disregard of the above mentioned testimony, but the Board declined to do so. As no judicial review or application was brought by the taxpayers against the Board s ruling of not to state a case on that question, the taxpayers cannot now seek to go behind the Board s ruling by asking the COA to examine the disregarded evidence to impugn the Board s findings.

3 combination of different legislative provisions 2 as suggested by the taxpayers. The takeaway The issue of capital versus revenue has always been controversial given the fine line between the two and the tax amount that is generally involved. While the ultimate finding is very often a matter of degree and factspecific, one key message for taxpayers from the COA s judgment in this case is that activities within certain scope performed by a taxpayer to enhance the value of its capital asset before disposal would not necessarily render the transaction an adventure in the nature of trade. However, taxpayers need to be cautious about what are being regarded as going beyond that safe zone. From the perspective of better managing the tax appeal process under the existing case stated procedures 3, this case illustrates that great care needs to be exercised by a taxpayer in the various stages of the process (e.g. in drafting the questions of law in the stated case and in considering whether to challenge the Board s decision not to include certain questions in the stated case by means of judicial review) as that may affect the taxpayer s ability to make certain submissions or put forward certain arguments when the case is heard in the court. Endnotes 1. The Enhancement for realisation principle was applied in various cases including Hudson s Bay Co Ltd v Stevens (1909) 5 TC 424 and Taylor v Good 49 TC 277. The principle establishes that activities relating to the enhancement of the value of one s capital asset for the purpose of sale would not necessarily point towards a change of intention to one of trading. 2. The two ordinances that the taxpayers sought to rely upon are: (1) Hong Kong Sheng Kung Hui Ordinance (Cap 1157) and (2) Hong Kong Sheng Kung Hui Foundation Ordinance (Cap 1159). 3. The existing case stated procedures for tax appeals are being reviewed by the HKSAR Government and it is expected that legislative changes will be proposed by the HKSAR Government to replace the cases stated procedures with a simpler procedure of directly appealing to a court on questions of law. 3 PwC

4 Appendix: Actions taken by the taxpayers in redeveloping the land and disposing the redeveloped properties September 1989 Early 1990s December 1990 May 1993 July 1993 August 1993 November 1993 December 1993 March 1998 August 1998 The re-provisioning of the orphanage was treated as a separate project and the taxpayers applied for planning permissions to redevelop the land into a residential area. Architects commissioned by the taxpayers submitted various plans to the HKSAR Government for the purposes of obtaining planning permission for a substantial residential development on the land. Architects appointed by the taxpayers applied for a land exchange to permit the building of the residential development as approved. A land premium of HK$704 million was agreed between the taxpayers and the HKSAR Government. The taxpayers invited various developers to submit tender offers either to purchase the land outright from the taxpayers or to enter into a joint venture with the taxpayers for the redevelopment of the land. The taxpayers accepted the tender from one of the developers for forming a joint venture for the redevelopment. The taxpayers surrendered the land to the HKSAR Government in exchange for a new grant of the land. The taxpayers entered into a joint venture agreement with the selected developer for the redevelopment of the land as a private residential area. Certain number of residential units and car parking spaces on the redeveloped land were allocated to the taxpayers. An occupation permit for the development was issued by the HKSAR Government to 2006 The taxpayers sold the residential units and car parking spaces and derived a profit of around HK$1.1 billion. 4 PwC

5 Let s talk For a deeper discussion of how this issue might affect your business, please contact a member of PwC s Hong Kong Corporate Tax Team: Reynold Hung reynold.hung@hk.pwc.com Oscar Lau oscar.lau@hk.pwc.com With over 2,200 tax professionals and over 140 tax partners in Hong Kong, Macao, Singapore, Taiwan and 14 cities in Mainland China, PwC s Tax and Business Service Team provides a full range of tax advisory and compliance services in the region. Leveraging on a strong international network, our dedicated Hong Kong Corporate Tax Team is striving to offer technically robust, industry specific, pragmatic and seamless solutions to our clients on their Hong Kong, PRC and international tax issues. In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 29 September 2014 and were based on the law enforceable and information available at that time. This Hong Kong Tax News Flash is issued by the PwC s National Tax Policy Services in Hong Kong and China, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.